Will the Prime Brokers Lose Money on the Bear Stearns Funds?

There's a very scary tidbit hidden at the bottom of the NYT coverage of the Bear Stearns mortgage mess today:

One industry executive, who asked not to be named because of the delicacy of the subject, said the banks involved in the Bear funds could collectively lose $1 billion on their lendings to the Bear funds. While the amount is not itself significant given the size of these banks, it suggests the potential for bigger losses down the road.

This paragraph comes more than 1,100 words into a 1,300-word article, which is a bit weird, because it's the first I've heard of prime brokers actually losing money on their lendings – and losing a large amount of money, too. (No bank is so large that $1 billion isn't "significant".)

The idea behind prime brokerage, of course, is that you run very little risk. Your loans are backed by collateral, and if the collateral falls to near the value of the loans, then you seize it and sell it.

That doesn't seem to have worked in this case – not least because it's very hard to tell exactly how much the collateral is actually worth. A lot of it is tied up in CDOs which own chunks of other CDOs, and getting a bead on how much it's all worth is something which can take days.

All the same, it's quite astonishing that prime brokers could end up losing a ten-figure sum on lendings to a couple of pretty small Bear Stearns funds. If they do, then their total prime-brokerage exposure is enormous, and one can definitely see why the likes of Tim Geithner are worried about about the lack of regulation and proper risk controls in the prime brokerage industry.

Of course, there's always the possibility that the "industry executive," whoever he may be, has no idea what he's talking about – which might explain why his quote is buried so deep. But in that case, why include it at all?